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Direct Indexing: Passive investment with potential tax benefits

August 27, 2018

By: Rolf Agather, managing director, Research

In the United States—and many other countries—investors are required to pay capital gains taxes on profits generated from their investments. Since US regulations require mutual funds and ETFs to pass any capital gains to shareholders annually, tax efficiency can be limited for these index vehicles. Separately managed accounts (SMAs) that fully replicate an index—thus providing a solution that can offer a tax benefit—have generally only been available for large investors. An innovative solution called Direct Indexing enables indexes to be passively tracked even in accounts with small balances.

Taxes are often a primary consideration for the taxable investor. In fact, a key driver behind the rise of ETFs is their tax efficiency relative to index mutual funds. Due to their unique structure, most ETFs are able to eliminate their capital gains to shareholders through the creation/redemption process where their index mutual fund peers often distribute an annual capital gain.

While ETFs can be more tax efficient than mutual funds, they are both limited in that they cannot pass-through capital losses to shareholders. SMAs have the potential to provide this additional tax benefit. SMAs follow a defined investment objective—like a mutual fund or ETF—but individual securities are owned directly in the investor’s account. Holding individual securities directly in the account facilitates tax loss harvesting on an individual security level, thereby offering the potential to offset other income that investors file on their annual tax return. However, to date, this type of fully replicated passive investing hasn’t been available in SMAs for investors with smaller account balances.

Holdings transparency. Account statements show individual securities owned and the number of shares/bonds of each security owned.

FTSE Russell has licensed its indexes to SMArtX Advisory, who maintains a Unified Managed Account (UMA) platform and has partnered with Black Diamond to provide performance reporting. Black Diamond recently hosted a webinar—with SMArtX and FTSE Russell participating—to discuss Direct Indexing and the ease of implementation and performance reporting on the Black Diamond/SMArtX platform. The webinar highlighted the ease of building, rebalancing and managing Direct Indexing portfolios across hundreds of individual client accounts. It also discussed implementing tax loss harvesting through Direct Indexing and the simplicity of client reporting that rolls hundreds of individual stocks into a single line item on client performance reports. Watch my portion of the webinar presentation now.

We believe Direct Indexing in UMAs may be attractive to some investors. A UMA allows an investor to hold ETFs, mutual funds, individual securities and SMA strategies all in a single account. UMA implementation is executed by an overlay manager, or an investment manager whose sole purpose is to execute trades. UMA overlay managers that license FTSE Russell indexes can offer a FTSE Russell index to investors to be directly and fully replicated in portfolios with tax loss harvesting.

The chart below highlights the similarities and differences between Direct Indexing and ETFs.

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